Currency Choices in Valuation: An Approach for Emerging Markets

Abstract

One of the common issues in Valuation in emerging markets is the choice of the currency for the Valuation and how it affects the inputs. Very often, multinational companies, when valuing an investment or an acquisition in an emerging market, are required to express expected cash flows in a strong currency, usually dollars. Since these investments generate sales, expenses and cash flows in domestic currency, it is necessary to forecast the exchange rate for the investment horizon.

In this paper we demonstrate the equivalence of the fair value independent of the currency used in the valuation, forecasting the exchange rate using the yield spread observed in market bonds, providing a framework that can help senior management to analyze the assumptions consistency.

Although a controversial issue arises, since the simultaneous fulfillment of Interest Rate Parity theory (IRP) and Purchasing Power Parity theory (PPP) implies that the Real Exchange Rate (RER) remains constant for the explicit forecast period, the model can be extended to assess the impact on the business value as a consequence of a different evolution of the real exchange rate.

Keywords: Valuarion, Emerging Markets, Interest Parity Theory, Purchasing Power Theory, Currency Choices

JEL Classification: F23, G24, G30, G31